STOCK MARKET

Mid-Year Emerging Markets Update: ‘Recovery Phase’

As I’ve often said, investing in emerging markets requires patience, long-term perspective, and selective stock-picking. I think many investors focus too much on the short-term. As long-term investors, we view short-term bouts of volatility as an opportune time to find potential bargains for our portfolios, and we certainly experienced that in the first half of the year. Sentiment in emerging markets seemed to be at a particularly low point at the very start of the year, coming off a weak 2013.

As the US Federal Reserve (Fed) started tapering its quantitative easing program, fears seem to have surfaced that liquidity would dry up, and concerns about potentially slower growth in China this year gave some investors pause. Headlines of conflict and violence in countries including Ukraine, Turkey, Thailand and Nigeria also affected overall investor sentiment in the first half of the year, along with doubts about the readiness of Russia to host the Winter Olympics and Brazil to host the FIFA World Cup.

On the brighter side, India’s market saw a post-election resurgence of hope, China’s economy did not experience a hard landing and the upgrade of Qatar and United Arab Emirates to emerging markets status from frontier appeared to fuel investor interest. We believe emerging markets overall are now in what could be classified as a “recovery phase” after 2013’s underperformance, barring no further unexpected shocks.

We believe it’s important to look at the big picture as an investor in emerging markets. During the last 10 years, there have been only three years when emerging markets underperformed developed markets, 2013 being one of them.1 In the first half of 2014, emerging markets have generally outperformed developed markets,2 and I would say that we’re in a sweet spot in terms of emerging markets’ recovery. And, we think a number of frontier markets, the even lesser-developed subset of emerging markets, look particularly attractive right now.

Investors Noticing Emerging Markets

We believe some of the fear surrounding emerging markets last year and early this year now appears overblown. From a liquidity perspective, the Fed is not the world’s only liquidity provider: Japan has implemented its own quantitative easing program, China’s monetary base has increased, and the European Central Bank (ECB) recently announced a new swath of stimulus measures. It is also important to note that, to date, the Fed has not sharply tightened policy to slow an overheating economy. On the contrary, the US economy appears to be coming off life support as the extraordinary policy measures of recent years are being gradually unwound.

Many US investors were (and still are) underweight emerging markets according to our research, but we’ve recently seen some increased interest. We suspect that the excitement about the US market as it recovered from the 2007 – 2008 financial crisis caused people to put money there and keep it there. Now we have seen interest in spreading some of those assets to other markets. The same sort of investor dynamic seems to be taking place in Europe. After a recent seven-country tour around Europe, I was happy to find increased investor interest in emerging markets. People seem to be starting to diversify their assets a bit more.

Indonesia’s experience illustrates this increased global investor interest. After a sharp decline in both equities and the rupiah last year, foreign exchange reserves have risen back above US$100 billion,3 the rupiah has appreciated and many of the stocks most heavily sold off in 2013 have seen positive returns thus far this year.4 We believe such positive performance of many emerging markets could continue as we move into the second half of 2014.

Brazil: Sporting Economic Growth – and Political Change?

There’s been a lot of number crunching about the impact of major sporting events on a country’s economy and market. Brazil’s current leadership has been criticized for the spending spree on the FIFA World Cup and the 2016 Olympics. No doubt, Brazil was in need of improved infrastructure, but the debate has been whether resources have been funneled to the right places, for the right reasons, and whether the economy will ultimately benefit.

A key point to consider is that while international sporting events may not provide the kick-start to growth for a country that many hope for, they can provide an opportunity for the people to demonstrate to the world that they are unhappy with their government. We’ve seen that in the case of Brazil. I think predictions of economic disaster or World Cup or Olympics chaos probably have been overblown.

Brazil’s experience in hosting high-profile sporting events could ultimately prove an example of how the acceleration of change can take place when people have a greater voice. The rise of the Internet, and more importantly the rise of cell phones and smartphones, has played a key part. It remains to be seen how the people’s discontent will play out at the polls during Brazil’s general election in October, but we will be watching. We believe the inverse correlation of Brazilian equities with President Rousseff’s popularity demonstrates how populist government intervention in markets can be detrimental to growth. If the opposition party is victorious in the next election, there could be dramatic changes for the better, particularly in the area of encouraging greater private enterprise. But even if the current government remains, people are demanding change, so I think we could very well see it regardless.

“A key point to consider is that while international sporting events may not provide the kick-start to growth for a country that many hope for, they can provide an opportunity for the people to demonstrate to the world that they are unhappy with their government. We’ve seen that in the case of Brazil.” There are a number of key elections coming up in emerging markets that could prove quite revolutionary. In India, Narendra Modi’s landslide victory proved within a short period how quickly sentiment and stock prices can change. We believe the reform outlook for many emerging markets looks the brightest it has in years. China’s government under President Xi has signaled its intention to embark upon extensive reform, and in Indonesia, presidential frontrunner Joko Widodo has announced ambitious plans to cut subsidies and increase investment. These are just a few examples.

From an investment standpoint, the use of smartphones has had a big impact globally, changing not only the political climate, but the consumer one as well. Mobile shopping, banking and payment systems are now at the fingertips of people in markets where most of the people just a few years ago had almost no method of fast and widespread communication. The impact of the Internet is incredible, in our view. We are finding bloggers in emerging markets mentioning products, Facebook communities in emerging markets where people buy and sell from each other, to name a few examples. I think this leapfrogging of technology has the potential to accelerate growth as well in many countries, which essentially don’t have to bear any cost of restructuring, or even building, brick-and-mortar stores and bank branches. Companies can now reach people in remote places they never could before. This is exciting, but does not necessarily mean we focus solely on the consumer sector, where valuations might be elevated relative to other sectors. We take an unconstrained approach in that we don’t make decisions based on a particular benchmark, and can gain indirect exposure via banking stocks with strong micro-lending businesses, or the industrials sector in transportation, for example.

The Case for Active Management

We are bottom-up value managers and, hence, what is most important to us are the fundamentals of individual stocks, rather than top-down macroeconomic considerations. Our portfolio allocations to countries and sectors are driven by stock selection. Accordingly, we are able to find attractive investments globally, including in countries where negative news flow may obscure stock opportunities. From a global perspective, some of the most exciting opportunities, we think, are in frontier markets. These can be viewed as essentially the next generation of emerging markets and include countries such as Nigeria, Saudi Arabia and Vietnam, which have experienced good growth.

Of course, just because you have high growth in a country doesn’t mean that the companies in that country will all have high growth. Now, admittedly, if you have a high growth country, there’ll be opportunities for a good company to do better than they would be in a low-growth country, but this can depend on competition and many other factors.

We believe the broader positive trends we’ve seen in emerging markets, relative to developed markets, include higher growth rates, lower levels of debt and higher foreign exchange reserves. These provide a potentially positive macroeconomic backdrop, complemented by booming consumer growth.

However, short-term volatility is likely something we will continue to deal with for the rest of 2014 and beyond. In some cases, unfortunately, the reaction of some governments will be to enact more repression. There will be bad news in places, and there will be some companies that fail. We have to be prepared for that as investors – and be prepared to act when opportunity knocks.